Goldman’s Options Error Shows Peril Persists After Knight

For all the efforts to shore up electronic markets in the aftermath of one of America’s biggest trading catastrophes, yesterday’s options malfunction by Goldman Sachs Group Inc. shows the dangers haven’t gone away.

A programming error caused the firm to send unintentional stock options orders in the first minutes of trading, pushing prices on dozens of contracts to a dollar each, according to a person briefed on the matter yesterday and data compiled by Bloomberg. Any losses for Goldman Sachs, the fifth-largest U.S. bank by assets, won’t be known until exchanges determine which contracts should be canceled, said the person, who requested anonymity because the information is private.

Investors who fret about the increasing dominance of electronic exchanges say the error at Goldman Sachs, which generated about half its revenue from trading last quarter, shows that worse breakdowns are inevitable. A year ago, Knight Capital Group Inc. was pushed to the brink of bankruptcy by a trading breakdown, and Chinese regulators are investigating broker Everbright Securities Co. after $3.8 billion of incorrect buy orders sent the Shanghai Composite Index up about 6 percent in two minutes last week.

“It can happen to anybody, no firm is immune,” Matt McCormick, who helps oversee $9.6 billion as a money manager at Cincinnati-based Bahl & Gaynor Inc., said in a phone interview. “Because it’s Goldman Sachs, the error could be pretty large.”

Sorting Trades

Exchanges were working to sort out the trades and any loss “would not be material to the financial condition of the firm,” according to an e-mail from David Wells, a spokesman for New York-based Goldman Sachs. The company’s shares slipped 1.5 percent to $157.11 today.

An internal system that Goldman Sachs uses to help prepare to meet market demand for equity options inadvertently produced orders with inaccurate price limits and sent them to exchanges yesterday, according to the person familiar with the situation. Some of the transactions have already been voided, data compiled by Bloomberg show.

Error trades took place in the session’s first 13 minutes for tickers beginning with the letters I, J and K and most of the transactions may be canceled, according to a statement dated yesterday from NYSE Euronext’s U.S. options business. NYSE and Nasdaq OMX Group Inc. said today that they have completed the trade reviews, according to e-mailed statements from the exchanges.

Options Trades

Representatives for other U.S. options market operators -- Nasdaq’s Robert Madden, CBOE Holdings Inc.’s Gail Osten, International Securities Exchange LLC’s Molly McGregor and Bats Global Markets Inc.’s Suzanne O’Halloran -- all declined to comment.

“As is our practice, we have been monitoring developments and talking with the exchanges and other market participants as appropriate,” Securities and Exchange Commission spokesman John Nester said in an e-mail.

Of the 500 biggest options trades in the first 15 minutes markets were open yesterday, 405 of them were for tickers starting with H through L and priced at $1, according to data compiled by Trade Alert LLC and Bloomberg. Almost 130 of those were in 1,000-contract lots.

Busting Trades

“To bust a trade in equities it’s relatively straightforward, to bust a trade in options it would take more time,” Howard Tai, a Kansas City, Missouri-based analyst with Aite Group LLC, said in an interview. “You need to look at each one of the factors and then run through a sanity check, and say, ‘Beyond the cash equity price at the time it happened, how did everything else affect it?’”

Investors in China were whipsawed by a computer malfunction last week. State-controlled brokerage Everbright reported a trading loss of 194 million yuan ($32 million) and apologized to investors after errors in order-execution systems on Aug. 16 sparked the biggest intraday swing in China’s benchmark index since 2009. The incident touched off a 53 percent surge in volume in the Shanghai Composite Index, which jumped from a loss of as much as 1 percent to a gain of 5.6 percent in two minutes.

Everbright’s stock plunged by the 10 percent daily limit yesterday after the China Securities Regulatory Commission banned the brokerage from proprietary trading for three months and started investigating what it described as the first incident of its kind in China. The company said today that it suspended its head of proprietary trading.

Goldman, Knight

At Knight, computers spewed orders onto exchanges on Aug. 1, 2012, that created a more than $450 million loss for the brokerage. The mishap forced the company to near-insolvency before it was acquired by Getco LLC and spurred calls to examine whether increasing automation is damaging markets.

Knight had a $1 billion market value on July 31, 2012, the day before the trading error, according to data compiled by Bloomberg. Its stock fell 33 percent the next day. Goldman Sachs, which saw its stock rise 0.6 percent yesterday, has a market capitalization of $75 billion.

Goldman Sachs reported net income of $1.93 billion in the second quarter on a surge in underwriting revenue and gains from the firm’s own investments. In the quarter before its trading mishap, Knight posted net income of $3.3 million.

Written Policies

The SEC proposed rules in March requiring U.S. exchanges and some brokers to conduct coordinated trading tests to show they can recover from disruptions. The mandate, called Regulation Systems Compliance and Integrity, directs exchanges to strengthen their technology and instruct member firms to participate in tests to show they can sustain operations after interruptions.

The proposed rule requires firms to have written policies and procedures to ensure that systems supporting trading, clearing, order-routing and surveillance have sufficient capacity and remain available to their users. The technology must operate as intended, be secure from threats and promote fair and orderly markets. A review must be done at least once a year by objective personnel, the SEC said.

The changes by trading firms, exchanges and regulators are making the industry better at navigating technology mishaps and human errors, said Ben Schwartz of Lightspeed Financial Inc.

The securities industry has “learned from the mistakes we’ve made in the past and tried to grow a technology to simplify a process and grow more consistent,” Schwartz, the Chicago-based chief market strategist at broker Lightspeed Financial, said in a phone interview yesterday. “It’s a positive thing that they react immediately in a timely manner.”

Canceled Trades

Among yesterday’s canceled trades, 241 September $103 puts on the iShares Russell 2000 Exchange-Traded Fund traded at $1 at 9:32 a.m. New York time, according to data compiled by Bloomberg. That price was down from $3.32 two minutes earlier. At the same time, 1,000 October $90 calls on Johnson & Johnson traded at $1, followed less than 11 minutes later by two contracts at $2.10.

“We’re all working too fast, too thin and we’ve got systems that do things for you,” said Tim Hartzell, who helps manage about $425 million as chief investment officer at Sequent Asset Management in Houston. “You can make so many little errors.”